Trendy fund is ‘Stupid Investment of the Week’

Commentary: Trendpilot ETN does a simple job at a princely price

BOSTON (MarketWatch) — The investment world is filled with good ideas that, when turned into a mutual fund, deliver bad performance.

For proof, look to RBS US Large-Cap Trendpilot
TRND
, an exchange-traded note that began trading early in December and, fresh out of the box, is the Stupid Investment of the Week.

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Stupid Investment of the Week highlights the flawed thinking and worrisome characteristics that make a security less than ideal for the average investor, and is written in the hope that showcasing trouble in one case will make it easier for consumers to avoid trouble elsewhere. While obviously not a purchase recommendation, this column is not intended to be an automatic sell signal.

The RBS Trendpilot situation is an interesting one because, on the surface, the investment looks like a good way for individual investors to follow a strategy that they might believe is fundamentally sound, but difficult to implement on their own.

Paying a service fee

Simply put, Trendpilot
TRND
invests in the stock market when the Standard & Poor’s 500 Total Return Index (measuring the S&P 500-stock index’s
SPX, +0.59%
actual return plus dividends) is above its 200-day moving average, and it invests in cash — trying to get the return of the 3-month Treasury bill — when its S&P 500 benchmark is trading below the 200-day moving average.

The idea behind Trendpilot is simple: The trend is your friend. Invest when it’s going good and sit on the sidelines when it isn’t.

It’s so simple, in fact, you could do it yourself — and a whole lot better. But for many investors, their reason to hire a money manager would be for the personal discipline it takes to live with the strategy; the fact that most investors would not have that wherewithal actually also shows some of what’s wrong with Trendpilot.

To see how that’s possible, let’s dig a little deeper.

First, exchange-traded notes (ETNs) are similar but different than the standard exchange-traded fund, or ETF. Both types of securities track an index, trade like a stock and are liquid, but ETFs are structured so that the investor owns the underlying basket of securities. If the ETF were to go bust, the shareholder usually would get cash for the market value of the securities. (If an investor has a huge chunk of the fund — say 50,000 shares — they might be allowed to take their payout in stock.)

ETNs, by comparison, are debt instruments issued by big banks, Royal Bank of Scotland in the case of RBS Trendpilot. As a debt instrument, the ETN doesn’t actually own anything; instead, it is making a promise to track an index and pay out the way an investment in the index would. If an ETN fails, an investor will not get the investment back. The average investor probably should think of an ETF like buying a stock, with the ETN like buying a bond.

The difference is important because an investor who wants to replicate the Trendpilot strategy would not have a hard time doing it by making the actual investments. They could use a Standard & Poor’s 500 ETF when they want to be in the markets, and Treasury bills or money-market accounts when they want to be out.

At the very least, they would save money. Trendpilot charges 1% in management fees when it is “invested” in the market, and a 0.5% fee when it’s in cash. An investor could make the same investments for about one-tenth the cost, although they would have to pay transaction costs for the trades they make.

Behind the curve

Further, Trendpilot waits five days to confirm the buy or sell signal. The market has to be above its average for five days before Trendpilot turns positive, and below it for five days before “going to cash.” Money managers who use moving averages typically act when the line is crossed; in fact, a do-it-yourself investor could use most financial Web sites to track the moving average and send them alerts when a trade should be triggered.

“If it really is trying to follow the trend, then it should move when the trend changes,” said Tom Lydon, editor of the ETF Trends newsletter. “Give the trend a five-day cushion, the way this fund does, and you will leave some money on the table on both ends, when you are buying and selling.”

Some people might be willing to pay that price, just for the ease of having someone else make the trades, but there’s a reasonable question of whether Trendpilot can deliver on its promise.

While RBS is showing back-tested results for the index — which was created only in mid-November — those numbers may have been helped along by times that happen to make this strategy look good. In fact, the back-tested results undoubtedly were boosted by the fact that over the last half-decade, a flat market was followed by a huge downturn, and then a rebound; plug in different results — and all we know about future returns is that they will not exactly mimic the past — and the back-tested “success” quickly turns to mud.

Moving-average strategies work best when the market has long, substantial trends, either up or down; when the market has no real trend, they tend to get whipsawed. That’s why average investors have trouble following them, because in a direction-less market they are doing a lot of trading — potentially losing money in both directions — hoping for something to materialize.

In the end, Trendpilot isn’t likely to hurt investors — it’s built to reduce risk and it’s not going to send anyone to the poor house — but it’s probably not going to deliver the kind of returns they expect from the strategy either.

“I prefer strategies that work fairly well through most kinds of market environments,” said Mark Salzinger, editor of The Investor’s ETF Report, “so that investors can hold on to what they have and not sell near bottoms or buy near tops.”

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